How P2P can take the strain of tighter bank capital rules

I am City A.M.'s deputy business features editor. I look after the Entrepreneurs page, Alternative Finance and our Office Politics section. I also help out with the Forum, running our daily debate. I have a special interest in distributed ledger technology. Prior to working at City A.M., I ran a social enterprise.

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Harriet Green

P2P can help banks deleverage by taking on higher-risk loans

Harriet Green asks Assetz Capital where platforms will go from here – and where the pitfalls lie

Should retail investors be worried about the rise of institutional money in the peer-to-peer (P2P) industry? What should we think about the growing role of funds within it? And is it just banks who will find their business bitten into by the alternative lending sector? Could P2P lead to a new banking model?

These are all questions posed by the growth of the P2P industry. The Liberum AltFi Volume Index, which measures deal flow on platforms, topped £5bn in cumulative volume for 2015 this month, and with this growth has come greater innovation.

I caught up with Stuart Law and Andrew Holgate, the chief executive and managing director respectively of Assetz Capital. Their company enables private and institutional investors to lend direct to small businesses. It has also waded a bit further onto the banks’ territory than its peers, offering a quick access investment account, which has a capped interest rate of 3.75 per cent gross per annum. Come April 2016, it’ll also offer an innovative finance Isa account.

The firm thinks that easy access to money is a crucial challenge to solve for any investment product, and that offering it is the way to really open up P2P to the mass market. I asked Law and Holgate about their take on the industry, its relationship with banks and what its future holds.

Does P2P pose a threat to banking?

SL: The relationship between banks and P2P is symbiotic – we don’t see it as pure competition. Banks are naturally retreating from certain areas and we can step into them.

The Bank of England’s proposed capital buffer [which will force banks to set aside capital to support lending during a downturn, and which could come into force as soon as March] won’t help banks. It’ll affect interest rates – in that it could push them up. And it’ll impact capital intensive lending, like SME business loans and buy-to-let.

Banks don’t want to lose most consumer or business relationships or stop lending as a whole. But if they can find a way to take the very low-risk parts of the market that haven’t got much capital requirement, we can step in and take on some of the perceived “high capital weighting” loans that are too costly in capital or cost for a bank to take on.

From the investor side, the capital buffer is interesting too. Banks will either go off and raise shareholder capital, or they will attempt to reduce risk (whatever that might mean), or they’ll reduce lending.

But customers need banks for other services, right?

AH: Yes, and they’re systemically vital because of it. First, because of the payment systems they control. Cash only accounts for about 3 per cent of the money in circulation in the western world now, so the electronic infrastructure the banks have is critical.

Second, because they create money through the fractional reserve system. For every £10 that goes in as deposits, £90 or so is going out in new lending. The leverage banks can produce to improve the money supply is critical. Where they got it horribly wrong was taking the lending deemed to be higher risk to unacceptably high levels. What P2P is able to do is take away that higher risk lending and put it in a non-leveraged position. That still leaves banks in a position to create money in less risky areas, like mortgages and personal loans.

We’ll never replace banks – they’re simply too important to the country’s credit supply. But we can deleverage them and help them reach their capital adequacy requirements.

Some fund managers say they’re interested in P2P, but they won’t go near it until it’s gone through a cycle. Is that reasonable?

SL: Yes, I think it is, actually, in some cases. Zopa has already been through a cycle, and we, for instance, are using Bank of England stress test modelling to show the high resilience in our traditional secured lending model – but there are lenders who have got completely untested algorithmic models and the difficulty there could be in unsecured lending. If you’re lending against property and it’s a simple, solid security, you’ll have defaults, but will you have losses with modest “loan to values”? If something goes wrong, the impact will be limited. If your model is wrong, you might see higher than normal default rates. But if you’re dealing with unsecured lending, that could convert to a large loss. Commentators have got it right in being wary of mass market, high volume, unsecured lending until it’s been through a full cycle.

And there’s another factor when you go into a downturn and start seeing default rates. The loan-to-value ratio increases which, in turn, hits the risk-weighted asset calculation. It becomes more expensive for banks to lend. But P2P doesn’t have the issue of risk-weighted assets, which means we can ride out the storm. If your lenders are happy to sit tight and hold the assets, you can be more flexible through a downturn. The issue arises when the market becomes super hot. We all remember when Northern Rock offered 110 per cent mortgages, banking on property prices rising. The financial system cannot go through that again – and we have to make sure it doesn’t.

How important is the evolution of funds within the space?

SL: We’ll certainly see more funds – more permanent sources of capital for P2P lenders. Look at LendInvest. It created a permanent vehicle with a fund and later became a P2P lender. Others are doing similar, but the other way around, like Funding Circle. In-house funds are definitely a strong way forward, and they’ll possibly become one of the most important elements of P2P. The thing to consider is how much skin in the game there is for the platform versus the fund – that’s what investors will want to know.

AH: At the moment, it is still a question of viability. The industry is still in the nascent period of platform growth and finding ways to raise finance. As platforms grow, they won’t want to just use up all sources of capital; having pools available so they can keep lending will be critical.

A concern is that some platforms – and not necessarily in the UK – are taking short-term cash and using it against long-term lending. Because we (Assetz Capital) have got hundreds of millions of institutional funding behind us, we know that capital is committed for the long term. It also means we can plan how to become a more sustainable and profitable business.

Presumably, you don’t agree that increasing numbers of funds will squeeze out retail investors?

SL: No. The idea of retail money competing with P2P funds couldn’t be further from the truth. If you could look forward five years, you’d see funds taking on the riskier end, not retail. It’s not the future to have retail money taking on risk – it needs to be protected.

Anyone who says retail money will be used to fund high-risk while funds take the low-risk tranches isn’t close enough to the market. Funds like risk; it’s where they make money. Retail investors don’t like risk, which is why they give funds their money. When people understand that, the industry can come up with some innovative and helpful strategies.

We’ve talked about the relationship between banks and P2P. Should the asset management industry be worried?

SL: Yes, categorically. It’s not so obvious (as it is with banks) how they can work with us. There’s arguably some overlap when it comes to distribution, but fund managers? That needs some thought. And perhaps the P2P industry generating lots of healthy coupon income, the holy grail of investment assets at present, has value in the wider investment and pensions industry. We think so.

In specific areas, pension funds have long been interested in the private rented sector, but haven’t been able to get much of a look in to date. Now, the 3 per cent stamp duty surcharge for buy-to-let and second homes will help them compete with private landlords. But why should that industry have any kind of monopoly? Why shouldn’t crowdfunding compete with institutions in the private rented sector? It’d avoid the tax, and it’d bring costs down.

STAT OF THE WEEK from CityAMCrowdwatch.com

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CONSUMER GOODS FIRMS ACCOUNT FOR 6% OF THOSE CURRENTLY RAISING FUNDS ON PLATFORMS